Beyond IWM: Five Intriguing Small Cap ETFs

Although most U.S. investors build their portfolios around a core of large cap domestic equities, small-cap firms, which generally have a market capitalization’s under $2 billion, are a vital component as well. Because small cap stocks tend to have smaller customer bases, shorter operating histories, and less cash on hand, they are often more volatile than their large cap counterparts. But because they possess greater growth potential, small caps also carry potential for greater returns.

Many investors elect to complement large and mid cap equity positions in their portfolio with a small cap ETF that offers exposure to a diversified basket of stocks. The most popular ETF in the Small Cap Blend ETFdb Category is the iShares Russell 2000 ETF (IWM), a fund that is comprised of 2,000 of the smallest companies in the Russell 3000 Index. IWM’s broad-based exposure–both in terms of number of securities and sector weightings–has made it the default option for investors seeking to add small caps to their portfolio. But IWM certainly isn’t the only option among small cap ETFs;below we profile five unique funds that may be worth a closer look:

PRFZ tracks the FTSE RAFI US 1500 Small-Mid Index, a benchmark designed to track the performance of small and medium-sized U.S. companies that presents an interesting alternative to traditional market cap weighting. Companies are selected based on the four ” fundamental” measures of size: book value, cash flow, sales and dividends. Each of the equities from the universe of potential components with a fundamental weight ranking of 1,001 to 2,500 is then selected and assigned a weight equal to its fundamental weight. The fundamental weighting aims to eliminate the problems of market-cap weightings by breaking the link between share price and weight (for an in-depth explanation of the fundamental weighting method, see (Does Your Portfolio Need A “RAFI ETF?”). PRFZ’s performance in 2010 has been impressive; it’s up about 7% on the year.

IWC measures the performance of the microcap sector of the U.S. equity market, offering exposure to the smallest publicly traded companies on the market. While companies of this size entail high risk, they also have a high potential for gains. The index underlying IWC consists primarily of companies with a market capitalization between $50 million and $550 million. The average market cap is about $350 million, compared to more than $1 billion for IWM.

FDM tracks the Dow Jones Select Microcap Index, which is designed to represent microcap stocks trading on the New York Stock Exchange, NYSE Amex and Nasdaq that have strong fundamentals relative to the microcap segment as a whole. FDM uses quantitative screening methodologies to identify microcap stocks expected to outperform the broad market, analyzing a variety of financial indicators including price-to-earnings and per-share profit change for the previous quarter (see AlphaDEX ETFs Turn In Impressive Performance).

RWJ also offers an alternative to traditional market capitalization weighting methodologies. This fund includes the same component stocks as the S&P Small Cap 600, but determined the weighting given to each based on top line revenues rather than market cap. This methodology also breaks the link between stock price and allocations, thereby avoiding the tendency of many benchmarks to overweight overvalued stocks and underweight undervalued securities (see Revenue-Weighted ETFs: New Twist On An Old Drink).

DSC follows the Dow Jones U.S. Small-Cap Total Stock Market Index, a subset of the Dow Jones U.S. Total Stock Market Index, which measures all U.S. equity securities with readily available prices. The index represents the stocks ranked 751-2,500 by full market capitalization and is float-adjusted market cap weighted. Again, DSC allocates to a variety of market sectors with financials (22%) receiving the highest weighting. DSC has outperformed IWM by a slight margin so far in 2010, climbing about 7% on the year.

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